OPINION: Prime cause of sub-prime crisis
Anonymous. Businessline. Chennai: May 14, 2008.  
        
                    Abstract (Summary)Washington'smisjudgement has inflicted enormous costs. It first tripped theeconomy. It then ripped the mortgage industry. But America's commercial banksare liquid and solvent. There are no Northern Rocks. Northern Rock is aBritish mortgage bank that was devastated by mortgage defaults; it wasnationalised in February 2008.
So, the commercial banksells the ten loans as an unsorted bunch to an investment bank at, say,$1,020. The investment bank's core competence lies in selling the loansas ten securities, say, at $105 per security. The interest andprincipal (the periodic mortgage obligation) paid by the ten borrowerswill then be paid to the holders of the ten securities. Securitisationrestores liquidity to the commercial bank. Moreover, the commercial bank and its depositors are not exposed to the risk of default by borrowers.
The commercial bankapplies risk-based pricing to the other five borrowers that are morelikely to default. They are perhaps more vulnerable to economicdownturns. So, it lends to these 'sub- prime' borrowers at T-bill rate plus 8 per cent. The five loans to the sub-prime borrowers are sold to the investment bank at, say, $480. The investment bank then creates five securities from the sub-prime bunch and sells each at, say, $100. The lower price reflects the higher risk

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